At the time of an initial public offering (IPO), a company that comes to market is judged by its business prospects, the dynamics of the sector that it is exposed to, as well as factors that could determine its success or failure.

In today’s competitive business world, some factors are outside the control of a company, which could make a company irrelevant, and this of course are factors like the pandemic situation that we are facing now, technological changes, economic shocks, financial turmoil, or even catastrophic events like an earthquake or tsunami.

There are also cases where companies failed due to their mismanagement and this includes lack of business acumen, the inability to respond to market changes, or even a potential case of a good business plan but poorly executed or a plan that was too ambitious to begin with.

While these factors, both internal or external, could be reasons for the failure of a business, there are also cases whereby a company is able to ride the changing business environment by diversifying away from its focus area, both either vertically or horizontally or even by venturing into a new business altogether.

This is where investors’ patience is tested, as companies that are diversifying away from their core business need to make sure that they have the right expertise and knowhow to excel in the business that they are diversifying into.

Since the start of the pandemic, a slew of companies have announced plans to diversify away from their core business, hoping or trying to catch the pandemic-driven demand in certain businesses that are or were thriving.

This is known as the conglomerate or unrelated diversification strategy, where the main driver of the decision is based on the company’s view that the new business will ignite growth for the company and provide significant return on investments.

Top of the list is diversifying into the glove manufacturing sector. We have seen companies from different sectors going into the glove business and this includes those from the property, technology, hospitality and services sectors, and even those from the utility sector.

Of course, the key attraction for these companies is the lure of profits that come from the relatively high global demand for gloves, which has driven average selling prices (ASPs) of gloves to record high levels.

But as seen in the recent third quarter report card from the world’s largest glove manufacturer, Top Glove Corp Bhd, both volume and ASPs are now on a downtrend, as more capacity is added by not only existing players but the newbies in the sector.

Nevertheless, the glove manufacturing business is expected to remain very profitable with the earnings before interest, tax, depreciation and amortisation margin remaining at elevated levels, although the peak of 60%-70% may not be repeated.

Hence, these new players, despite not having the requisite knowledge nor experience, may still scrape through with profits over the next one to two years, provided market demand is sustained.

Don’t forget, while these newbies are installing new capacity, the existing players are ramping up production too and it is obvious who would come out tops.

Do what you know best

One of the investment mantras for fund managers is focusing on companies that are doing what they know best and ensuring that they continue to do so, not only to gain market share but to enjoy the economies of scale that comes with size.

For example, let’s assume that a company is a construction-based company, and over time it has proven to be able to deliver results with sustainable growth and earnings momentum.

With that, just because the glove sector is the “market theme of the season”, does it make sense for it to diversify into glove manufacturing?

Would it better for investors to focus on companies that already have proven to be the best in the field instead of banking on a newbie to deliver spectacular profits?

In this case, assuming the company is well followed by analysts, the target price will be raised because of the expected lucrative “extraordinary profit” that the company is going to deliver.

In the meantime, not a single glove has been produced, but the company’s valuation, based on a sum of parts method, is already matching its construction business valuation.

The best part is the company’s glove venture business has reached a valuation that is at least seven times to eight times of the value of its investment into the venture itself. Does it make sense to value the business venture on short-term peak ASP and high demand?

And why should investors buy the shares of these newbies into a business that they know nothing about?

If an investor believes in the glove story, would it not be appropriate for an investor to focus on companies that have glove manufacturing in their blood and veins?

Making sense of diversification

Not all diversifications are bad. Some are good or some are forced upon a business as they may be in a sunset industry. The mantra “either change or be changed” is very relevant here and hence companies that are in this sunset industry got to start thinking ahead to venture outside their traditional business models.

History has shown how companies like Eastman Kodak became irrelevant after digital cameras were introduced and led to their demise later on.

In Malaysia, we have seen how our listed tin mining companies exhausted their revenue source as mines were depleted and they had no choice but to diversify into other businesses.

A company like Malaysian Mining Corp, which was Malaysia’s largest tin mining corporation back in the late 1970s and early 1980s, diversified into other businesses to remain relevant.

The company is now predominantly a port operator with interest in other businesses too, including in the utility and infrastructure sector.

The print media sector is another casualty of the changing business landscape, and hence, while players in the industry do maintain their focus on the core business activity, they are also diversifying to remain relevant.

We have also seen companies diversifying via either vertical integration or horizontal diversification. In vertical integration, a company builds up its presence along the supply chain of its business, while in horizontal diversification, a company simply adds another product or service to its existing customer base to increase its revenue.

One listed real estate investment trust (REIT), due to the pressure from the retail sector and of course mainly due to the pandemic as well as changing consumer behaviour patterns, obtained the approval of its shareholders to expand its investment mandate beyond the retail sector and to include commercial, office and industrial segment.

This is a classic case of the company seeing the challenging business environment in the retail segment and looking to venture outside its focused area.

Nevertheless, as this is still related to its core business activity, the move to diversify away from the retail segment is seen as timely as the company will now be known as a diversified REIT with different asset classes, once it is able to build up its portfolio.

Hence, when it comes to diversification, a company must ensure that it has the right reasons for doing so. For vertical or horizontal diversification, the reasoning is rather straightforward but for conglomerate diversification strategy, companies must be careful as to what they are venturing into to ensure the limited capital available is deployed efficiently and not merely venturing into a business to keep up with the Joneses.

The article was first published here.

Photo by Christopher Burns on Unsplash.